UGBS 003

ECONOMICS

Session 5: Elasticity of Demand and Supply

DR ABEL FUMEY
 • Meaning of elasticity of demand & supply
• Demand
• Calculating elasticity of demand
• Determinants of Price Elasticity of Demand
• Types of demand curves
• Price Elasticity and Total Revenue
• Application of price elasticity of demand

Objectives • Supply
• Calculating elasticity of supply
• Determinants of Price Elasticity of Supply
• Types of supply curves

• Other Elasticities
 • Elasticity refers to “responsiveness” or
“stretchiness”.

• Elasticity of demand (supply) is the measure

of the responsiveness of quantity
Concepts of demanded (supplied) to changes in price.
Elasticity
• That is, the extent to which a change in the
price of a good will cause a change in
quantity demanded (supplied), other things
held constant.
 • Note three types of elasticity of demand

PRICE Price elasticity of demand

ELASTICITY
OF DEMAND Cross price elasticity of demand

Income elasticity of demand

 Price Elasticity of Demand
• Price Elasticity of demand is the percentage change in the quantity of a
good demanded divided by the corresponding percentage change in its
price

• Measures the responsiveness/sensitivity of quantity demand to changes

in price.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑
• 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
 Calculating Price Elasticity of demand
• Given the demand for good X, compute the percentage change.
𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 −𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒
• 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 % = ∗ 100
𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒
• Going from A to B,
150 −300
the % change in P = ∗ 100 = −50%
300

P • Similarly, % change in 𝑄 =
30−20
∗ 100 = 50%
20

• Price elasticity of demand = 1

$300 A
• Going from B to A,
$150 B
300−150
the % change in 𝑃 = ∗ 100 = 100%
150

Q • Similarly, % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 = −33.33%

20 30 • Price elasticity of demand = 0.033

• Notice that the Price elasticity “ignored” the negative sign!

 Conti…
• Therefore, to avoid the differing answers which depends on the
starting point, use the mid-point formular.

Here,
𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 −𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒
• % 𝑐ℎ𝑎𝑛𝑔𝑒 = 𝑚𝑖𝑑𝑝𝑜𝑖𝑛𝑡
∗ 100

• The midpoint point is the average of the two values.

 Conti…
• From the earlier example,
150 −300
• % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 𝑓𝑟𝑜𝑚 𝐴 𝑡𝑜 𝐵 = ∗ 100 = −66.67%
225
30−20
• % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑓𝑟𝑜𝑚 𝐴 𝑡𝑜 𝐵 = ∗ 100 = 40%
25

40%
• Therefore, 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = = 0.6
66.67%

Activity
• Use the midpoint method to calculate the Price elasticity of demand (from B to A)
• What do you observe?
 Determinants of Price Elasticity
1. Availability of close substitutes
• Quantity demand for goods that have substitute(s) is very responsive to changes in price
because buyers can easily switch if the price increases – high price elasticity
• Conversely, quantity demand for goods with no close substitute(s) is not very responsive
to price changes - low price elasticity

2. Definition of the market

• Quantity demand for goods that are broadly defined is less responsive to price changes.
• For goods that are narrowly defined, quantity demand is very responsive to price
changes.
 Conti…
3. Necessitates vs. Luxuries
• Price elasticity is relatively higher for goods that luxury than necessities.

4. Time frame/horizon
• Price elasticity is higher in the long run that in the short run
 Types of Demand Curves
• The type of demand curve depends on the price elasticity of demand, which
is also related to the slope of the demand curve.

• Five types of demand curves

• Perfectly inelastic demand
• Inelastic demand
• Unit elastic demand
• Elastic demand
• Perfectly elastic demand

• The steeper the slope of the curve, the smaller the elasticity and vice versa.
 Perfectly Inelastic Demand
• Demand curve is vertical
• % change in quantity demand = 0
• Consumers (or quantity demand) are insensitive to price changes
• Elasticity = 0

P
D

P1

P2

Q
Q1=Q2
 Inelastic demand
• Demand curve is downward sloping and steep
• % change in quantity demand < % change in price
• Consumers (or quantity demand) are relatively less responsive to price
changes
• Elasticity < 1
P
D

P1

P2

Q
Q1 Q2
 Unit Elastic Demand
• Demand curve is downward sloping, and the nature of slope is intermediate
• % change in quantity demand = % change in price
• Consumers’ price responsiveness is intermediate
• Elasticity = 1
P

P1

P2

D
Q
Q1 Q2
 Elastic Demand
• Demand curve is downward sloping, and the slope is relatively gentle
• % change in quantity demand > % change in price
• Consumers (or quantity demand) are relatively very responsive to price
changes
• Elasticity > 1
P

P1

P2
D

Q
Q1 Q2
 Perfectly Elastic Demand
• Demand curve is horizontal
• % change in price = 0
• % change in quantity demand can be any %
• Consumers (or quantity demand) are extremely responsive to price changes
• Elasticity is infinity
P

P1=P2 D

Q
Q1 Q2
 Price Elasticity and Total Revenue
• 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑃 ∗ 𝑄
• An increase in the price of a good has two effects:
1. A high price – increase in revenue from each unit sold

2. But a high price also means sellers can sell fewer quantities because quantity
demand will fall (recall the law of demand)

• Notice that 1 & 2 move in opposite direction.

• Therefore, the overall effect on Total Revenue following a price increase will
depend on the price elasticity of demand
 Conti…
• If demand is elastic,
• Price elasticity of demand > 1
• i.e., % change in Q > % change in price
• Therefore, an increase in price will lead to a fall in Total Revenue

• If demand is inelastic,
• Price elasticity of demand < 1
• i.e., % change in Q < % change in price
• Therefore, an increase in price will lead to an increase in Total Revenue
 Conti…
Activity
1. If the Electricity Company of Ghana raises the tariffs on electricity by 15%,
does total expenditure on power rise of fall?

2. If the price of bread from Stella’s bakery is increased by 7%, will the bakery
record increase or decline in sales?
APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related
Crime?
• One side effect of illegal drug use is crime:
• Users often turn to crime to finance their habit.

• We examine two policies designed to reduce illegal drug use and see what effects
they have on drug-related crime.

For simplicity, assume

• the total dollar value of drug-related crime equals total expenditure on drugs.

• Demand for illegal drugs is inelastic,

• due to addiction issues.
 Policy 1: Interdiction
Interdiction reduces the new value of drug-
supply of drugs. Price of related crime
Drugs S2
D1
S1
P2
Since demand for drugs is
inelastic, P1 initial value
P rises proportionally more of drug-
than Q falls. related
crime

Result: an increase in Q2 Q 1 Quantity

total spending on drugs, and of Drugs
in drug-related crime
 Policy 2: Education
new value of drug-
Education reduces Price of related crime
the demand for Drugs
drugs. D2 D1
S

P and Q fall.
P1 initial value
of drug-
P2 related
Result:
crime
A decrease in total
spending on drugs, and in
Q2 Q 1 Quantity
drug-related crime. of Drugs
Cross price elasticity of demand
 Cross price elasticity of demand
• When two goods are substitutes, the cross price elasticity of demand is
positive.
 For example, when the price of margarine goes up, the demand for butter will rise too as
consumers shift away from the now relatively more expensive margarine to butter.

• When two related goods are complements, the cross price elasticity of
demand is negative.

• If goods are completely unrelated, their cross price elasticity of

demand will be zero.
Cross price elasticity of demand
INCOME ELASTICITY
 INCOME ELASTICITY

• A normal good has a positive income elasticity of

demand
• A inferior good has a negative income elasticity of
demand
• A luxury good has an income elasticity larger than one
• A necessity has an income elasticity less than one
INCOME ELASTICITY
 Calculating Price Elasticity of Supply
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑠
• 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

• For the same reason as stated earlier, use the midpoint method to
compute the percentage

i.e.,
𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 −𝑠𝑡𝑎𝑟𝑡 𝑣𝑎𝑙𝑢𝑒
• % 𝑐ℎ𝑎𝑛𝑔𝑒 = ∗ 100
𝑚𝑖𝑑𝑝𝑜𝑖𝑛𝑡
Types of Supply Curves
• The type of supply curve depends on the price elasticity of supply, which
is also related to the slope of the supply curve.

• Five types of supply curves

• Perfectly inelastic supply
• Inelastic supply
• Unit elastic supply
• Elastic supply
• Perfectly elastic supply
• The steeper the slope of the curve, the smaller the elasticity and vice
versa.
 Perfectly Inelastic Supply
• Supply curve is vertical
• % change in quantity supplied = 0
• Producers (or quantity supplied) are insensitive to price changes
• Elasticity = 0

P
S

P2

P1

Q
Q1=Q2
 Inelastic Supply
• Supply curve is upward sloping and steep
• % change in quantity supplied < % change in price
• Producers (or quantity supplied) are relatively less responsive to price
changes
• Elasticity < 1
P S

P2

P1

Q
Q1 Q2
 Unit Elastic Supply
• Supply curve is upward sloping, and the nature of slope is intermediate
• % change in quantity supplied = % change in price
• Producers’ price responsiveness is intermediate
• Elasticity = 1
P
S

P2

P1

Q
Q1 Q2
 Elastic Supply
• Supply curve is upward sloping, and the slope is relatively gentle
• % change in quantity supplied > % change in price
• Producers (or quantity supplied) are relatively very responsive to price
changes
• Elasticity > 1
P
S

P2

P1

Q
Q1 Q2
 Perfectly Elastic Supply
• Supply curve is horizontal
• % change in price = 0
• % change in quantity supplied can be any %
• Producers (or quantity supplied) are extremely responsive to price changes
• Elasticity is infinity
P

P1=P2 S

Q
Q1 Q2
 The Determinants of Price Elasticity of Supply
• The more easily producers are able to (or can) change the quantity they
supply, the higher the price elasticity of supply

• Price elasticity of supply is higher in the long run than in the short run
Reference
• Mankiw, G. (2012). Principles of Economics (6th Edition), South Western.

• Begg. D., Vernasca, G., Fischer, S. & Dornbusch, R. (2011), Economics, 10th Edition,
McGraw-Hill.